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Quit Throwing Gasoline on the Fire

The terrible cost of a "stable" market.

Remember Enron? As we suffer through the current financial crisis, it's worth remembering what exposed that company's fraud: a footnote. More specifically, a footnote that referenced the company's off-balance-sheet controlled companies that housed the tremendous debt the company didn't want you to know about.

As a result of the Enron scandal, we got Sarbanes-Oxley. The whole point of that legislation was to put an end to creative, off-balance-sheet accounting by making C-level executives personally responsible for the accuracy of a company's books. Sarbanes-Oxley was supposed to restore the world's faith in America's accounting and financial systems by making it abundantly clear that a company's reported numbers were accurate.

The cost of "doing something"In light of that legislation, it's almost ironic that the current subprime crisis was caused by hyper-complex, bad debt that so many institutions strove so hard to keep off their balance sheets. If anything, the subprime meltdown essentially proved that Sarbanes-Oxley failed miserably. Not only did it fail to prevent off-balance-sheet shenanigans, but look at how poorly the American market has performed compared to the rest of the world since that law was signed in July 2002:

Index Tracker

Region

Total Gain Since
Sarbanes-Oxley

SPDRs (AMEX: SPY)

USA

66.0%

iShares MSCI Japan (NYSE: EWJ)

Japan

63.0%

iShares MSCI EAFE (NYSE: EFA)

Europe, Australasia, and Far East

133.7%

iShares MSCI EMU (NYSE: EZU)

Europe

166.4%

iShares MCSI Pacific ex-Japan (NYSE: EPP)

Pacific/Asia (excluding Japan)

234.0%

iShares MSCI Canada (NYSE: EWC)

Canada

255.3%

iShares MSCI Brazil (NYSE: EWZ)

Brazil

1252.2%

Even the markets in the "moribund" economies of Japan and Europe kept pace with or outperformed America's S&P 500 in that time frame. That should give pause to any legislator who's considering supporting Treasury Secretary Hank Paulson's "Blueprint for Regulatory Reform." Bad regulations passed in a panic during a crisis may be worse than the disease they're trying to cure.

We're from the government, and we're here to helpAfter all, the Federal Reserve, the very agency that Paulson wants to morph into the "market stability regulator," shares a large chunk of the blame for this crisis. It was Alan Greenspan's Fed that kept rates too low for too long, which encouraged the risky lending practices in the first place. Under Greenspan's successor, Ben Bernanke, the Fed has gone on to:

More or less kill capitalism by eliminating the risk to the participants in any transaction.

This is the model regulatory agency that's going to be in charge of assuring "stable" markets? Talk about the fox guarding the henhouse.

The safety net that killsThe very concept of a market stability regulator should send shivers up your spine. If there is any lesson to be learned from the current subprime meltdown, it's this: Risk cannot be eliminated, only transferred. While the Fed's poor policy execution laid the foundation for the housing bubble, the derivative securities made up of subprime mortgages helped foster an illusion of safety.

That illusion enabled the poor loan underwriting practices and bad decision-making that let the housing bubble get out of hand. In the end, once the mortgages that made up those securities were shown to be largely worthless, the bubble burst, taking down some very prominent financial firms with it. Now imagine that the illusory safety net was provided by the Federal Reserve and backed by the currency it controls -- the U.S. dollar. The pain when the bubble that that scheme enables bursts (and like all bubbles, it would burst) would make this crisis seem like child's play.

Unshackle the invisible handPerhaps worst of all, in this power-hungry quest for unlimited government control over financial markets, one thing was lost: the simple fact that the free market still works. If the government would just stop trying to "help," the housing and subprime mortgage markets would find their bottoms. And once those bottoms were hit, they'd provide the solid foundation for the much-needed recovery to blossom.

Yes, there would be short-term pain. But just like tearing a bandage off a hairy arm, it's better to get it over with quickly than to pick at it slowly and painfully over a brutally long period of time. That is, of course, unless you think Japan's decade-long economic stagnation is a model worth emulating.

Fool contributor Chuck Saletta wonders if anyone else thinks "market stability regulator" reeks of something out of George Orwell's 1984. At the time of publication, Chuck did not own shares of any company mentioned in this article, and he's glad he turned down the job offer from Enron. The Motley Fool owns shares in SPDRs. The Fool has a disclosure policy.

Author

Chuck Saletta has been a regular Fool contributor since 2004. His investing style has been inspired by Benjamin Graham's Value Investing strategy. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.